All The Devils Are Here: Unmasking the Men Who Bankrupted the World (54 page)

There was another problem with the “sophisticated investor” defense. These deals were so complicated that in many cases
nobody
understood the risks, not even the underwriter. Yet investors—even sophisticated investors like IKB—were buying deals like Abacus for a simple reason: they didn’t want to lose money. Triple-A-rated securities were supposed to be the closest thing an investor could get to a risk-free investment. If Goldman knew that a triple-A rating no longer meant what it once had—and that these complex securities carried far more risk than their ratings implied—did it really have no responsibility to say anything? Shouldn’t there have been a point at which Goldman just said no? If Paulson’s bet paid off, it would happen because millions of Americans were losing their homes. Wasn’t that worth thinking about before deciding to go through with the Abacus deal? In 2004, Scott Kapnick, who had headed Goldman’s investment banking department, had said to
Fortune
, “The most powerful thing we can do is say no.” But by 2007, Kapnick, like many other senior bankers, had left the firm.

On March 7, 2007, Tourre sent an e-mail to his girlfriend. “I will give you more details in person on what we spoke about but the summary of the US subprime business situation is that it is not too brilliant … According to Sparks, that business is totally dead, and the poor little subprime borrowers will not last so long!!! All this is giving me ideas for my medium term future, insomuch as I do not intend to wait for the complete explosion of the industry.”

That same day, the Goldman Sachs Firmwide Risk Committee heard a presentation from the mortgage desk. According to a summary of the meeting, the first bullet point read, “Game Over—accelerating meltdown for
subprime lenders such as Fremont and New Century.” The second bullet point: “The Street is highly vulnerable, potentially large exposures at Merrill and Lehman.”

On June 24, Gary Cohn, at the time Goldman’s co–chief operating officer, sent an e-mail to Viniar and several others, noting both the big losses Goldman was taking on the mortgage securities it had been unable to “distribute” and the even bigger gains it was booking from its short position. Viniar’s response: “Tells you what might be happening to people who don’t have the big short.”

Later, the Senate Permanent Subcommittee would charge Goldman with making a fortune—$3.7 billion—by betting against its customers when it knew the market was going to fall apart. But that’s not really what happened. The huge gains Goldman made from its short position in 2007 were offset by substantial losses from the securities it couldn’t get rid of. Indeed, the firm made less money than it might have, because at certain points during the meltdown, most notably in the spring of 2007, Goldman covered its short position. It didn’t envision the “wipeout scenario,” as Paulson had. Rather, it was trying to figure out what the market was doing and stay one step ahead of it. Overall, Goldman’s mortgage department made $272 million in the first quarter of 2007, lost $174 million in the second quarter, made $741 million in the third quarter, and made $432 million in the fourth quarter. In total, Goldman’s mortgage department made $1.27 billion in 2007, a big number, obviously, but not even close to the $4 billion John Paulson made. “Of course we didn’t dodge the mortgage mess,” Goldman CEO Lloyd Blankfein wrote in the fall of 2007. “We lost money, then made more than we lost because of shorts.” True enough.

Other firms besides Goldman were also trying to dump their exposure onto buyers who hadn’t figured out that the ratings had become degraded. Other firms also sold synthetic CDOs while keeping a short position. But Goldman was unquestionably better at it than its competitors. What Goldman Sachs really did in 2007 was protect its own bottom line, at the expense of clients it deemed disposable, in a conflict-ridden business that maybe—just maybe—the old Goldman Sachs would have been wise enough to stay away from.

In all the subsequent frenzy over who did what to whom in the synthetic CDO market, a series of deeper, more troubling questions tended to get
overlooked. One was this: What, exactly, was the point of a synthetic CDO? It didn’t fund a home. It didn’t make the mortgage market any better. It was a zero-sum game in which the dice were mortgages.

“Wall Street is friction,” said Mark Adelson, the former Moody’s analyst. “Every cent an investment bank earns is capital that doesn’t go to a business. With an initial public offering, you get it. But with derivatives, you can’t tie it back. You could argue that at least it’s not hurting things, and that was a compelling rationale for a long time.” He concluded, “We may have encouraged financial institutions to grow in ways that do not directly facilitate or enhance the reason for having a financial system in the first place.”

If only that were the worst of it. But it wasn’t. The invention of synthetics may well have both magnified the bubble and prolonged it. Take the former first. Synthetic CDOs made it possible to bet on the same bad mortgages five, ten, twenty times. Underwriters, wanting to please their short-selling clients, referenced a handful of tranches they favored over and over again. Merrill’s risk manager, John Breit, would later estimate that some tranches of mortgage-backed securities were referenced seventy-five times. Thus could a $15 million tranche do $1 billion of damage. In a case uncovered by the
Wall Street Journal
, a $38 million subprime mortgage bond created in June 2006 ended up in more than thirty debt pools and ultimately caused roughly $280 million in losses.

As for prolonging the bubble, synthetics likely did it in two ways. Firms were much more willing to buy and bundle subprime securities from some of the worst originators knowing they could use a synthetic CDO to hedge any exposure they might be stuck with. Would Goldman have sold over $1 billion of Fremont mortgages to investors in early 2007 if it hadn’t been able to enter into credit default swaps to hedge some of its own resulting exposure to Fremont? Without the means to off-load these exposures, investment firms would likely have been more cautious—and shut off the spigot sooner.

Secondly, selling the equity in the CDO, the riskiest piece, required finding buyers willing to take that risk. There weren’t that many to begin with, and once they had enough equity risk on their books and stopped buying, the market for mortgages would have naturally wound down.

But around 2005, some smart hedge funds began to realize that there was a compelling trade to be made by buying the equity in a CDO while shorting the triple-As. If the mortgages performed, the return offered by the equity pieces, which could be upwards of 20 percent, more than covered the cost of the short. And if the mortgages didn’t perform? Then the short position
would make a fortune. It was a classic correlation trade. It was also practically foolproof.

The arrival of this trade may have been the final bit of juice that the market needed to keep from running out of gas. No longer did the underwriter have to find buyers willing to take on the equity risk. Instead, buyers of the equity slice could not have cared less about the risks in that portion of the CDO. If the equity made money, they made money. If the equity lost money, they made even more money. Suddenly, the equity portion was a very easy sell.

This trade gained popularity just when it looked on the ground like the subprime madness was grinding to its inevitable end. Instead, the business kicked into one last crazed frenzy, as subprime originators handed out mortgages to anyone and everyone.

“Equity is the holy grail of CDO placement,” wrote Lang Gibson, the Merrill Lynch CDO researcher. “The compelling economics in the long ABS correlation trade [buying the equity while shorting more senior tranches] will propel the mezz CDO market forward, no matter the evolution of fundamentals in residential mortgage credit, in our view.” Which is exactly what happened.

In January 2007, Tourre sent another e-mail to his girlfriend. “Work,” he wrote, “is still as laborious, it’s bizarre I have the sensation of coming each day to work and reliving the same agony—a little like a bad dream that repeats itself…. When I think that I had some input into the creation of this product (which by the way is a product of pure intellectual masturbation, the type of thing which you invent telling yourself: ‘Well, what if we created a ‘thing,’ which has no purpose, which is absolutely conceptual and highly theoretical and which nobody knows the price?’). It sickens the heart to see it shot down in mid-flight…. It’s a little like Frankenstein turning against his own inventor….”

Of course, the one thing that was neither conceptual nor theoretical was the losses. They were all too real, and in 2007, as winter turned to spring, they were coming.

On Friday, March 2, 2007, a man named Ralph Cioffi, who ran two hedge funds at Bear Stearns that had some $20 billion invested in asset-backed securities, held a small, impromptu meeting in his office. Matt Tannin, who managed the two funds with him, was there, as was Steve Van Solkema, a young analyst who worked for the two men and another partner in the funds. They had gathered to discuss the deteriorating market conditions. The week had opened with a drop in the stock market of more than 400 points, the largest one-day decline since the aftermath of 9/11. Cioffi described February as “the most treacherous month ever in the market.” They talked about the plunge in value of the riskier tranches of the ABX index. Even some of the triple-A—the
triple-A
—were showing a strange wobbliness. That wasn’t supposed to happen—ever. The men were anxious.

On paper, their two hedge funds hadn’t performed that badly: one fund was down a little; the other was up a little. But it had suddenly become difficult to obtain prices on the securities they owned, so they couldn’t be sure what their funds were truly worth. Plus, they’d often told investors that the funds operated like a boring, old-fashioned bank—they were supposed to earn the difference between their cost of funds (a good chunk of which were
provided through the repo market) and the yield on the super-safe, mostly triple- and double-A-rated securities that they owned. Investors expected fairly steady, low-risk returns.
Any
losses, no matter how small, could spook them. The Bear team had made money on short positions they had placed on the ABX, but the volatility was worrisome. Because the higher-rated securities were supposed to be nearly riskless, the Bear Stearns hedge funds were highly leveraged: only about $1.6 billion of the $20 billion was equity. The rest was borrowed. Earlier in February, they’d started to get margin calls, meaning that their lenders were demanding more collateral. They’d met the margin calls, but their fears had not abated.

Trying to calm the others, Cioffi told them about the time he and Warren Spector, Bear’s co-president, with whom Cioffi had risen through the ranks, had been caught with a big bond position way back when. They didn’t panic, and they ended up making a lot of money. Tannin commiserated with Van Solkema about how the stress made it hard to get any sleep. For Van Solkema, it was comforting to hear that even the “big senior guys,” as he later called them, weren’t sleeping, either. And then Cioffi opened a small fridge in his office and took out a very good bottle of vodka. They all did a shot out of paper cups, toasting to better times ahead.

Cioffi also suggested that they keep the discussion among themselves, which Van Solkema interpreted to mean that they should try to avoid worrying other employees.